Reputational Damage and Reassignment Pay

This paper asks whether it is optimal for a firm to pay a loss-averse agent for losses due to demotion and reassignment caused by a bad fit on an assignment, in a hidden-action setting. It is optimal for the firm to fully pay the agent for such losses with a contingent payment if the degree of loss aversion is high. When the degree of loss aversion is low, no payment for loss recovery is optimally made. We characterize the optimal contract and show that profit, utility, and welfare are enhanced when the firm follows this strategy.